I have been a CPA for over 30 years focusing on taxation. I have extensive experience with partnerships, real estate and high net worth individuals.
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IRS Position On Wandry Decision Makes 2012 Gifting More Difficult

The IRS has thrown a significant road block into planning for large 2012 gifts. Our transfer tax system , gift and estate taxes, is unified. There is a credit against gift tax that if not used during a person’s lifetime is available to the estate. For the rest of 2012 the credit covers $5,120,000 in taxable transfers. Based on law in place now, that amount goes to $1,000,000 on January 1. For people who have not dipped into the $5,120,000 credit equivalent, the case for a large gift in 2012 can be compelling. There are of course problems and complications. Among them are deciding what to give and making sure that you leave yourself enough assets to live on. The IRS announcement of non-acquiesence in the Wandry decision has made things difficult. I wrote about the Wandry decision several months ago. I indicated that setting up a gifting vehicle using the decision was even better than having Dr. Who, the Time Lord, helping you with your estate plan

Imagine someone with “legacy assets”. Legacy assets are things like illiquid real estate, rare artwork or family business interests that may not provide current earnings. Often there is a hope that legacy assets will never be sold. The legacy assets are owned by a family limited partnership. In addition to the family limited partnership interest, the person, let’s call him Joe, has three million dollars in liquid investments. Joe anticipates living on the three million dollars, perhaps depleting the principal as he gets older. The thing for Joe to give away would be units in the family limited partnership. How many units ? $5,120,000 worth of course. This is where knowing a Time Lord would be really handy.

Suppose the units are valued at $1,000. Joe gives away 5,120 units. The IRS challenges the valuation. Ultimately it is agreed that the units are worth $2,000. The gift tax, penalty and interest is going to take a pretty large chunk out of the three million dollars that Joe was counting on. This is where time travel would be really handy. After the case settles you ask Dr. Who to go back in time and instruct the attorney to make the gift 2,060 units rather than 5,120. There is a possible looping problem here. The valuation was the result of compromise and negotiation. Maybe, if you started at $2,000 you would have ended up at $2,200 requiring another trip back in time. The Wandry decision provided a much neater solution:

Although the number of Units gifted is fixed on the date of the gift, that number is based on the fair market value of the gifted Units, which cannot be known on the date of the gift but must be determined after such date based on all relevant information as of that date.

Furthermore, the value determined is subject to challenge by the Internal Revenue Service (”IRS”). I intend to have a good-faith determination of such value made by an independent third-party professional experienced in such matters and appropriately qualified to make such a determination. Nevertheless, if, after the number of gifted Units is determined based on such valuation, the IRS challenges such valuation and a final determination of a different value is made by the IRS or a court of law, the number of gifted Units shall be adjusted accordingly so that the value of the number of Units gifted to each person equals the amount set forth above …….

This elegant gift tax solution seems like it could create an income tax nightmare particularly if the units were gifted to multiple persons. You could never be sure everybody’s income tax return was right until the number of units finally transferred was determined. There is a solution to that problem. If the gift is made to one or more intentionally defective grantor trusts, the flow through from all gifted units ends up on Joe’s return regardless of whether the gifts are considered completed or pulled back.

So he may not be able to help you with your gift tax planning. A case can be made for actually paying gift taxes. The top rate is scheduled to go up to 55% from 35%. Even without a rate increase, gift taxes can be a better deal than estate taxes. The rates are the same, but there is a big difference. Estate taxes are computed on the gross, while gift taxes are computed on the net. Someone who has run through the unified credit who then leaves his heirs $1,000,000 will be leaving them a net of $650,000. With sufficient prescience, the $1,000,000 could have been used to make a gift of roughly $740,000 with the associated gift tax paid with the balance.

There are several reasons why the case for paying gift tax remains unpersuasive. One is the general rule that you should pay no tax before its time. Then there is the prospect of the Tea Party Triumphant amending the Constituion to ban the death tax forever. Given all the smart people dedicating their lives to coming up with clever estate planning ideas, it is only a matter of time before one of them comes up with a way that will make it possible for you to take it with you. Then wouldn’t you be sorry that you squandered it funding an Alaska dynasty and paying gift taxes ? The main problem, of course, is having to come up with cash.

The Wandry decision has not been overturned. In principle, it still works, but the IRS has thrown down the gauntlet on it. It would seem that relying on it for a mega-gift would be risky. If there is plenty of liquidity to pay the resulting gift tax if it does not work, it might be worth trying, but not otherwise. For those who are charitably inclined the Petter case, which was upheld by the Ninth Circuit is worth considering. Under the Petter formula units would be transferred to charity rather than coming back to the donor. Barring that, 2012 mega-gifts should be made with property that is not open to significant valuation adjustment.

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An issue that I have not seen addressed with regard to gifting now is what to do if most of the assets you have to gift are stock, and with a cost basis that is so low it is nearly zero (less than 5%). The quandry is whether losing the step-up in cost basis is worth it or should you sell the stock in your estate, pay the cap gains taxes in 2012, and gift the net.

In my case, I have a gifing POA for my mom who has late stage Alzheimer’s. She is otherwise healthy and could live several more years, or not. My sister and I use the dividend income from her stock (70%) and other sources (30%) to care for her. To take advantage of the unprecedented $5.12M exemption, we could sell her stock in her estate and gift the net after cap gain taxes. However, assuming we repurchased the same stocks in the same proportion with the net proceeds, we would lose the dividend income on the stock that was converted to cash and paid out in taxes. Oh, it is often forgotten to note that the federal cap gains tax at 15% for 2012 is not the only tax to paid. For many states (NY for example), cap gain is taxed as ordinary income. This adds another 9-13% to the tax bill, the latter if you are a NYC resident. So the total tax on cap gain could approach 28%.

My sister and I would use the income from the gift to continue our mom’s care. The factors to consider is whether the uncertain growth on the lesser amount of repurchased stock (higher cost basis) would offset the cap gain taxes paid in 2012 and lost dividend income going forward. Alternatively, transferring the stock (no cost basis step-up) needs to weigh against the growth of all the stock against future cap gains should the stock now be sold outside my mom’s estate. How many years of growth and at what conservative rate would make this advantageous on an after tax basis? Or, since we currently can afford to hold the stock indefinitely, it would pass with a stepped-up basis to our heirs (assuming the same egregious estate tax laws 10-30 years from now). I would love your opinion on this. I have just completed a very detailed Excel model that allows me to mix & match scenarios. Unfortunately, if we go over the “cliff”, any other scenario is better but still bad — a pick of the least worst.

A key point that most estate tax writers fail to make is, for federal estate taxes, all gifts are added back to the estate for the computation of estate tax. So it is really the difference you can gift this year at the higher $5.12M exemption vs. dying next year at a lower exemption that is being spared from estate tax. Also, if your state does not have a gift tax, the gift you make is not added back to your estate to compute estate tax. So state estate tax is lowered this way. However since state estate tax is a deduction against your federal estate, the more you gift, the smaller your state estate tax and the smaller your deduction. It’s enough to make you head spin. I know. Mine has been spinning.

Lastly, I presume time is running short for writing on this subject as the year end approaches. I would love to see your thoughts on the above. I think your readers would too.

You raise a lot of good points. I think each individual needs to sit down with a planner to go through their own issues. One technique that can be helpful is the intentionally defective grantor trust which will allow the older generation to pay the income tax subsequently so that you don’t have to sell right away in order to gift.

In your second to last paragraph you are alluding to the issue of “clawback” on which there is still some uncertainity.

Many thanks for your reply Peter! I am a believer in seeking expert counsel (i.e., not doing brain surgery on myself, it certainly feels like it though). Last year with the hullaballoo over what the Congressional Supercommittee might do, I employed several estate and tax professionals to advise me on just the situation I face now. We ran proforma estate tax returns, in addition to my Excel model. The results indicated that selling stock in my mom’s estate and paying the cap gains tax was a slight loss over the estate tax savings. One major faux pas, everyone ignored the state tax on cap gains (i.e., at ordinary income tax rates). At the 11th hour, I pulled the plug on the gift.

I understand your sound advice about the Intentially Defective Grantor Trust (IDGT). It would be great to accrue the growth of my mom’s stocks outside of her estate and yet pay the cap gains from her estate (thereby reducing it). The big question is: do assets in an IDGT get a stepped-up cost basis on the date they are contributed to the trust? If this is the case, it makes major sense for us. These assets in the IDGT would then valued for the estate on the date they are contributed? Are both these points true? I didn’t realize that the “clawback” issue was uncertain. I found a detailed publication on calculating 2011 estate tax from Montana State University (MSU.org, pub. # MT199104HR.pdf) which employs the clawback. Maybe I am mistaken that it was a previous law in which the clawback occurred only if the person died in less than 3 years from the date of the gift. Thank you again.

Thank you for correcting me. I sincerely appreciate it. I got all worked up at the possibility of a cost basis step-up. Oh well, back to my spreadsheet. I will look into the IDGT and look forward to your future column posts.